Transcript The Basics of Risk

The Basics of Risk
04/08/08
Ch.3
One of the major tenets of finance
 The higher the risk, the higher the return
required.
 In the corporate finance context:

A project should generate a return that is
appropriate for the level of risk of that project
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How do we define risk?
 Risk in general is the uncertainty of a future
event or outcome where there is some peril of
loss or injury.
 For stocks, it is the potential to either make or
lose money on the investment over time.
 For stocks, risk is often measured as the
variability or volatility of stock returns and
thus includes both potential worse-thanexpected as well as better-than-expected
returns.
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Types of Risk in a Finance World
 Project Specific Risk

Misestimated cash flow…risk or model
problems or both?
 Competitive Risk

How does competition impact outcomes?
 Industry Specific Risk

Why do companies share similar risks?
 International Risk
 Market Risk
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A closer examination of risk types
Figure 3.5: A Break Down of Risk
Competition
may be stronger
or weaker than
anticipated
Projects may
do better or
worse than
expected
Exchange rate
and Political
risk
Interest rate,
Inflation &
news about
economy
Entire Sector
may be affected
by action
Firm-specific
Actions/Risk that
affect only one
firm
Market
Affects few
firms
Firm can Investing inlots Acquiring
Diversifying
reduce by of projects
competitors across sectors
Investors Diversifying across domestic stocks
can
mitigate by
Affects many
firms
Diversifying
across countries
Actions/Risk that
affect all investments
Cannot affect
Diversifying globally Diversifying across
asset classes
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One way to measure risk?
 Variance of returns:
n
 
2
t 1
R  R
2
t
n
_
Where Rt is the return for period t, R is the average
return and n is the number of periods.
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Is variance an appropriate measure of
risk for all investors?
 No… variance is total risk of the asset but many investors do not
“carry” the total risk because…
 The risk calculated in the variance of returns for a stock includes
both firm-specific risk and market risk.
 An investor can eliminate all the firm-specific risk by holding a
diversified portfolio.
 Example of diversification as you add additional assets…rolling
the die
 One die…all the risk
 Two dice…central tendency starts and large outcomes (12)
or small outcomes (2) less likely
 Three…four…five...six dice…what is happening to the
distribution
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Moments of a distribution
 Moment one: mean
 Moment two: variance (standard deviation)
 Moment three: skewness
 Moment four: kurtosis
 Mean-Variance World


Bell-shaped curve (normal distribution)
Mean and variance completely describe the
distribution of the returns
 Adding Moments to the bell-shaped curve
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Which one do you prefer?
20
15
10
return (%)
5
0
-5
Stock 1
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20
stock 2
-10
-15
-20
-25
*The mean and variance of the returns are approximately the same
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Downside Only Risk?
 Semi-variance of returns:

n
2
semi

t 1
R  R
2
t
n
_
Where R is the average return over all periods, Rt is the
return for period t when less than the average, and n
is the number of periods where the actual return is
less than the average return.
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Is variance an appropriate measure of
risk for all investors?
 No, for the diversified investor, only market risk is important. The
firm’s beta is the appropriate measure of this market risk.
 What is Beta? Covariance of the individual assets return with
the return of the market…



Statistically measured with historical returns
What we really want is the relationship going forward
Future Beta?
 What does it mean if a firm’s beta is 0? Beta of 1? Beta of 2?
 Beta of zero…risk-less asset
 Beta of one…average risk asset
 Beta of 2, If the “market” goes up by 1% today, on average, the
firm’s stock price will go up by 2%.
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Asset Pricing Models
 CAPM
 Two parameter model, mean and variance

E(ri) = rf + βi (E(rm) - rf )
 Arbitrage Pricing Theory (APT)

Multiple factors

E(ri) = rf + β1 x F1 + β2 x F2 + β3 x F3 + …
 Multifactor Models (same as APT)
 Proxy Models
E(ri) = 1.77% -0.11 ln (MV) + 0.35 ln (BV/MV)
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Is Beta the right risk for others?
 Debt lenders?
 Where is there risk?
 No potential upside above the required
repayment of principal and interest
 Downside is not getting paid back…default
 How do you measure the probability of
default?


In theory…distribution of cash flows and
promise to lender
In practice…bond rating agencies
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Bond Ratings
 Who?
 What?
 When?
 Where?
 Why?
 How?



Firms “apply” for rating
Provide information to rating agencies
AAA to D ratings…(page 81)
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Determining hurdle rates (required
rates of return)
 A simple representation of the hurdle rate is
as follows:
Hurdle rate = Risk-free Rate + Risk Premium
 What we should use is the weighted average
cost of capital for that project…


WACC = E/V x Re + D/V x Rd (1 – Tc)
This shows the risk assumed by debt lenders
and equity owners proportional to their
investment in the project
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Practice Problems for Thursday
 Problem 7 – Standard Deviation of a Portfolio
 Problem 12 – Beta of a stock
 Problem 13 – Correlation between market
and stock
 Problem 14 – APT (called APM)
 Problem 15 – Multifactor Model
 Problem 16 – Fama – French Model
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